The following is in response to the debate on the role of luck versus skill among active managers. This debate was summarized last week.
The Manager Skill Enigma
C. Thomas Howard, PhD
Professor, Reiman School of Finance
University of Denver
and
CEO and Director of Research AthenaInvest, Inc.
September 30, 2008
A large number of studies address the question of whether US equity mutual fund manager skill is sufficient to produce superior returns. At the gross return level the answer to this question is a convincing yes. A range of studies show that the average US equity mutual fund manager produces a positive risk adjusted alpha. But when management fees are taken into account, the answer is not so clear. Some studies conclude managers cannot cover their fees, reporting average fund alphas (risk adjusted and net of management and other automatically deducted fees) in the range of -50bp to -150bp. On the contrary, other studies use screens that identify funds which generate positive after the fact alphas. What is more, this superior performance persists over time. So why do some studies show superior performance and others do not? In order to unravel this enigma, it is important to understand the underlying assumptions as well as the institutional and economic realities affecting the link between manager skill and fund returns.
Life of Fund Studies
The assumption underlying many large sample academic studies is that manager skill should reveal itself as a positive life of fund (LoF) alpha. These studies assume the skill-return relationship is constant over time and is not affected by changing institutional structure or the business cycle. The general conclusion of LoF studies is that there are very few managers who generate positive LoF alphas. This is discouraging for those looking for managers who can produce alpha over very long time periods.
The LoF assumption rules out the possibility that the relationship between skill and return is affected by a changing institutional structure or the business cycle. In many cases, the LoF approach is driven by the need for a large number of observations in order to demonstrate statistical significance. But if there is a dynamic relationship between manager skill and fund returns, the LoF approach will not capture it.
